This comment by Paul De Grauwe in the Financial Times, deserves more discussion that I can provide at this juncture (I am about to do a face plant), but I trust readers will find it a worthy offering.

De Grauwe focuses on sacred cows that have been gored in the credit crunch. He has written before, in more technical terms, on central bank reliance on models that deviate in key ways from observable reality. Nevertheless, despite his view that these constructs are taking a mortal blow, he also acknowledges that they still play a central role due to lack of obvious replacements.

The financial crisis continues to create victims. Not only people but also some of our most cherished ideas risk falling by the wayside. Take the hugely influential idea that financial markets are efficient. Its proponents told us that when financial markets were left free, they would work miracles. Savings would be channelled to the most promising investment projects, thereby boosting economic growth and welfare. In addition, these financial markets would spread risk around over a large number of participants, thereby lowering the risk of doing business, again boosting growth and welfare. In order to achieve these wonders, financial markets had to be freed from the shackles of government control.

The country that embodied these principles most was the US. Helped by the missionary zeal of successive American administrations and pushed by international financial institutions, country after country freed their financial markets from pernicious government controls, hoping to share in these economic wonders.

The credit crisis has destroyed the idea that unregulated financial markets always efficiently channel savings to the most promising investment projects. Millions of US citizens took on unsustainable debts, pushed around by bankers and other “debt merchants” who made a quick buck by disregarding risks. While this happened, the US monetary authorities marvelled at the creativity of financial capitalism. When the bust came, a large number of Americans who had been promised a new life in their beautiful homes were told to move out. This boom and bust cycle cannot have been an example of efficient channelling of savings into the most promising investment projects.

The fact that unregulated financial markets fail to deliver the wonders of efficiency does not mean that governments should take over. That would be worse. What it does mean is that a new equilibrium must be found in which tighter regulation is reintroduced, aimed at reducing the propensities of too many in the markets to take on excessive risks. The need to re-regulate financial markets is enhanced by the fact that central banks, backed by governments, provide an insurance against liquidity risks. Such insurance inevitably leads to moral hazard and excessive risk-taking. The insurer cannot avoid monitoring and regulating the be haviour of those who obtain this insurance.

There is a second idea that is likely to become the victim of the financial crisis. This is the idea found in macro economic models, that individuals are supremely well-informed creatures. In these models that are now being used in central banks and universities, individuals understand the most complex intricacies of the world in which they live and they have no disagreement about this. All these individuals understand the same “truth”.

If we have learnt one thing from the credit crisis it is that individuals did not understand the “truth” and, it must be admitted, neither did economists. Individuals who sold the new financial instruments did not understand the risk embedded in these instruments, nor did the buyers. When the bubble started many interpreted the happy turn of affairs as permanent and took on massive levels of debt that turned out to be unsustainable. When the bubble burst, they did not understand what had happened and nor did most experts. Our world is one of a fundamental lack of understanding of the “truth”.

But that is not the world of the macro economic models that are now in use in central banks. The world of these models is one of supernatural and God-like creatures for which the world has few secrets. These creatures can perfectly compute the risks they take and estimate with great precision how an oil price shock will affect their present and future production and consumption plans. They may not be able to predict each shock, but they know the probability distribution of these shocks. Thus the risk involved in financial instruments is correctly evaluated by individuals populating these models.

These superbly informed individuals want the central bank to keep prices stable so that as consumers they can optimally set their consumption plans with minimal uncertainty, and as producers they can set prices equal to marginal costs (plus a mark-up). If the central banks keep prices stable, these individuals, helped by well-functioning markets, will take care of all the rest and ensure that the outcome is the best possible one. This is a world in which free and unfettered markets are always efficient.

This is also a world where individual agents cannot make systematic mistakes. Their consumption and production plans are optimal. They will never build up unsustainable debts. In the world of these macroeconomic models financial crises should not occur. And if they do, it cannot be because of malfunctioning markets. Governments that impose silly constraints on rational individuals are messing things up, and central banks that do not keep their promises to maintain price stability are the source of macroeconomic instability.

This intellectual framework helps to explain the single-minded focus of many central bankers on inflation. Clearly, inflation is important and maintaining price stability is an important task of the central bank. It is not the only task, though. Financial stability is equally important. But this dimension is completely absent from the macroeconomic models now in use. In addition, since financial stability these days also depends on avoiding deep recessions, stabilising the business cycle should also be of the concern of the central bank.

Inflation in the euro area stood at 4 per cent in June. That is a problem. But is it an acute problem, compared with the disequilibria in the financial markets and the banking sector? When the European Central Bank raised the interest rate two weeks ago it took the view that inflation is the most important problem we face. No wonder the intellectual frame imposed on one’s mind by current macroeconomic models said that inflation is the number one enemy.

There is a danger that the macro economic models now in use in central banks operate like a Maginot line. They have been constructed in the past as part of the war against inflation. The central banks are prepared to fight the last war. But are they prepared to fight the new one against financial upheavals and recession? The macroeconomic models they have today certainly do not provide them with the right tools to be successful.

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22 comments

The FT is wrong, wrong, wrong! The market needs defending if it is getting blame even from the FT, of all institutions – the FT should defend the market.

The reason consumers, investors and banks made bad choices stems from one primary goverment failing.Goverment regulation of interest rates. Interest rates are the foundation stone of capitalism. It is the price of money. 500 years ago it was pretty much whe whole of capitalism. Today’s world is infinitely more complicated – but fundamental principles remain sound. In a free market there is a balance between supply and demand – only then can price discovery work. This applies to credit/debt markets. Only the market can drive the car of the “price discovery” of correct interest rates. This is the weighted synthesis of tens of millions of opinions of people lending and borrowing real money. It is the wisdom of the crowds.

Monetary policy committees, (FOMC, MPC etc) deciding interest rates is like a car being driven by a drunk. (interest rates decided by politicians is like a car driven by a drunk on drugs).

The reason we are in this crisis is that they fouled up. They manipulated interest rates until consumers, investors, banks could no longer make rational decisions about the price of money – because the feedback mechanism was/is broken.

Addendum. Low interest rates will prolong the credit crisis. This failure of government continues as we debate its cause…

Interest rates should reflect the scarcity of capital available for investment, which is a function of savings. Americans have no savings. Interest rates would never have gotten to 1% back in the early noughties, but Alan Greenspan mistook the dollars created by current account and trade deficits as ‘real savings’ in Asian countries. We had no real savings here to justify the huge debt loads that were taken on by consumers, businesses, and the government.

Andrew nailed it. The Fed is a price fixer. It sets the price of short term credit and has failed miserably. The system itself was doomed to fail when Nixon took the US off of the gold standard. It allowed huge imbalances in the flow of capital and trade to develop, and allowed the US the luxury of printing dollars in exchange for real goods. Our monetary system shipped jobs abroad, not our so called ‘free trade’ arrangements. After all these years, it looks like de Gaulle is being proven right, 40 years later.

I wanted to post a comment that challenged the article but Andrew Clifford and Danny have taken care of it…

‘Take the hugely influential idea that financial markets are efficient. Its proponents told us that when financial markets were left free, they would work miracles.’

The article overlooks the fact that the financial markets were not left free. The Fed has proven that it cannot replace the wisdom of the market to set interest rates. ‘Financial markets’ are not left ‘free’ as long as the Fed is around to stop the unseen hand of the market.

*sigh* Look markets simply ARE NOT efficient, and this has nothing _whatsoever_ to do with clumsy, inefficient government intervention. There are ample historical instances of market behaviors with no government restrictions which were manifestly irrational and inefficient. The historical data is the norm; modern economic theory said We Can Do It Better. So far, they haven’t, this is just their claim, efficiency. Nineteenth century positivism gauded out in new duds. Piffle. That’s without even raising, again, issues of systemicity which strongly lead inferences _away_ from the efficient market hypothesis.

As someone who spends no little time studying and modeling historical trajectories, I can say for a fact that individuals and societies ALMOST NEVER grasp ‘the truth’ about their current social context, even assuming that one can, post facto, identify central truths. This is not simply a perspectivistic error, nor one of cognitive incapacity. Rather, we focus on current spin and do not operate from sufficient temporal parallax: we see one surface of the moment, not the movement of the webbed interaction over time. Fools buying market top prices demonstrate this time and again, just as in so doing they time and again _disconfirm_ the efficient market hypothesis.

Furthermore, I am anything but sanguine regarding attempts ‘to mitigate the business cycle.’ Much of our current problem, in the US and in the ‘developed global economy’ derives from negative real rates, excessive stimulative interventions, and pro-cyclical biases. Sure, no one _wants_ a recession. But macroeconomic approaches to stimulating economies AS A WHOLE and by rates alone are damaging in their own way. It is one thing to develop government managed interventionary processes to mitigate losses to individuals, such as unemployment compensation and employment retraining programs. Those are good social investments which require government support to be genuinely effective and fair. But consider: why is it that we do not target our macroeconomic interventions? Small businesses disproportionately create new jobs—so why not grant THEM better interest rates and access to credit in downturns while letting the Big Boys fend for themselves? Why not subsidize retraining and education grants generally more in downturns? And so on, and so on: our tools are too few, too general, and too much designed to push up profits for the big players not for the economy as a whole. Don’t stand in the way of downturns, ameliorate them at the individual level. That changes the context without simply pouring out pubic largess upon plutocrats at the top of the financial chain who are anyway best positioned to take care of themselves. . . . Oh, but that’s (sorta) socialism. Sign me up.

I don’t know about “temporal parallaxes” but I do know about paradigm shifts.

Take the dot-com boom – market foul-up or not? NO! Reason is that the invention of the internet and mobile telephony was a major paradigm shift in our civilization. Of course the wealth-creatrtos are hard to value in the few years such a shift occurs. The dust has settled now. Who could have predicted that Cisco, Google, Amazon and Ebay would emerge triumphant. Do you remember Razorfish? A company that grew to $15 billion and collapsed like a soap-bubble. The market in telcos and dot-com companies was as efficient as it could be during a paradigm shift. This is not a criticism of markets – we should admire the darwinian ruthlessness of it. Natural selection of companies is fundamental to the high living-standards we enjoy.

There will be another paradigm shift within a decade when we transition from oil to solar/ethanol for transport. The high market price of oil is making that day happen less painfully.

Yet Congress voted 94-0 to begin purging speculators from the oil market. Those massed ranks of idiots they are – do they not realise that society is being helped by high oil prices. Can you imagine the disaster if oil was regulated to $65 per barrel (say) until the last barrel was drilled from the ground. Then we would see a civilization threatening collapse!

Wow, where can I get some of the crack going around in the comments section? Are you seriously trying to claim that the entire bust is the fault of the government’s failure to raise interest rates?

So the financial geniuses at all of our nation’s banks we’re fooled (Fooled I tell you!) by the Fed? Oh, and those sneak mortgage peddlers who pushed unaffordable mortgages on rubes in CA and elsewhere across the country of course. Come off it!

I’m not saying that easy money didn’t have an effect, but quite clearly the short-termism of the funds and the drive for ever-higher returns also plays a factor here. Shareholders don’t question too much as long as the share price keeps climbing. The firms say that they need to pay astronomical bonuses to staff for hitting near-term targets, and the end just gets uglier and uglier. This *is* the free market in its purest form, and it failed utterly because no one was watching the road ahead.

I don’t even work for a finance firm and I could have told you three years ago that something bad was in the offing because you can’t extend no deposit and huge multiples of annual income (as they did in Britain) to every-weaker households and expect it to end well. This wasn’t compelled by the British regulators, the banks went ahead and did it on their own in order to produce year-on-year growth.

So whatever the regulators’ role in this cock-up, it remains blatantly obvious that the ‘free market’ is just as incompetent when it’s ruled by just a few large firms with their eyes on the year-end bonus.

The models don’t take into account massive fraud. The banks gamed the system and suckered individuals into taking loans that were too good to be true. This was done with off balance sheet entities that were created by the these same banks who had the regulations removed that would have prevented them from committing this type of fraud. The problem stemmed from a lack of regulation.

Moral hazard became a macroeconomic rather than microeconomic phenomenon.

If central banks concentrated on their inflation objective, which common sense suggests is what their control of the money supply makes them best placed to achieve, it would be more worthwhile for ordinary people to make economic decisions carefully. While it suits the media and politicians to blame a specialist minority in institutions and businesses, the truth is that too many ordinary people cannot be bothered to do even the most basic research to guide their decisions (eg if I take out a mortgage, what is the highest interest rate I can stand and how likely is that interest rate likely to occur). They should bear as much as possible of any resulting losses themselves.

In my view, central banks should have no “financial stability” responsiblities whatsoever.

Astonishing. I thought I learned in the first week of macroeconomics 20 years ago that free markets are only efficient to the extent that externalities are internalized. Did someone finally disprove that crazy theory? Can the commenters who apparently are seriously proposing that “it’s all the government’s fault” please point me to where this basic premise was disproven? Funny, in all the years studying economics since, I must have missed that. After that, can you point me to the moment all actors acquired the perfect information they need to make sure the market is efficient after all the externalities are internalized? I can’t believe we are actually discussing this. Markets in anarchy are not efficient. Listen, I’m a borderline libertarian…”free markets are the worst way to organize an economy, except for the all the others.” But please, no more talk that the market would be efficient if the government just disappeared. There’s no point in discussing anything if we can’t agree to the most basic fundamental truth about the market. And beyond that, no democratic society is ever going to freely choose to eliminate the government’s role, especially in times of crisis. So even in the parallel bizarro universe that I’m wrong about anarchy leading to inefficiency, it’s not even a realistic outcome in democratic human society. So enough.

So now the story is “Free Markets can’t fail, and the fact that we are having so many problems now is simply proof of how Unfree the markets were”?Did I get that right? I guess that is what is to be expected what with all those radical socialists in the Chicago school and their pupils in the GOP having so much influence.

Give me a break. Free market ideologues sound more like Communists every day. Someday in the glorious future we will have a True Free Market, and then everything will be wonderful, and if it isn’t working out just yet that is because we haven’t been pure enough. We need more purity!

Or perhaps we should give up on searching for the utopia of a True Free Market and devote some time to looking for a macroeconomic theory that actually works in the real world, with mixed economies, interference from various actors both public and private, and taking into account the psychological imperfections of actual human beings. Last time I checked, there is plenty of research being done on behavioral microeconomics which tends to support the notion that macro inefficiencies in markets can arise from decisions based on limited and imperfect information made by actors who are prone to panics, manias and other symptoms of human social psychology. The problem in economics is that it is dominated by an old guard which refuses to let go of a fixed ideology that is breaking down in the face of evidence but has not yet undergone a Kuhnian paradiam shift (one which seems likely to occur within the current generation of younger economists).

A quick add-on to those types who actually believe we had a free market.

1) Government monopolies granted to the ratings agencies. Who came up with the bright idea that the people spewing this toxic crap should be paying for their own ratings? Ambac and MBIA were able to tell Fitch to stop rating them and removed access to their internal books.

2) Fannie and Freddie, paragons of the ‘compromise’ between free markets and government intervention are shown for the fraud that they are. They ENABLED the broker dealer business model of originate and distribute. They were able to ‘spread risk’ across vast swaths of mortgages, ship it to fannie or freddie, or even MBIA or Ambac, who both were given AAA ratings by the government sponsored rating agency monopoly, and then any products they spewed forth were given AAA ratings by those same monopolies. This was all to ‘grease’ the mortgage market wheels and make housing ‘affordable’.

3) The ‘Greenspan/Bernanke Put’ has been in place for over a decade now, allowing moral hazard to run rampant as even hedge funds like LTCM were ‘too big to fail’. I was just reading a book from a decade ago which pointed out that the US would never reach the sort of leverage that Japan had prior to their Lost Decade because companies in the US knew they wouldn’t get bailed out by the government. Well thank you Greenspan, thank you Bernanke, for the wonderful brew of moral hazard that has caused the insane amounts of debt and leverage to be built into the system.

4) How about the FHLB, who has ‘loaned’ Countrywide $50B+? What about the SBA, which has ignored fraud in it’s lending arms for years? What about our federal government, which has been the poster child for creating ‘off balance sheet’ liabilities and leveraging up its debt load?

As far as ‘efficient’ markets go, no, markets will never be perfect. They can be effective though, which is the goal.

And the idea of a ‘mixed’ economy is laughable at best. Go read your Hayek and Mises. Interventionism begets more interventionism. The common refrain now being spouted out is that free marketeers are ‘ideologues’. Why don’t you attack the ideas instead of throwing up abstractions? Markets will make mistakes because the actors within the market are humans. The mistake is assuming the government intervention will somehow solve those problems. Who comes up with the policies that government enacts? Yeah, that’s right, humans, so your ‘solution’ is circular. Humans in government are just as likely, if not more so, to enact policies that are mistaken.

Individuals who sold the new financial instruments did not understand the risk embedded in these instruments, nor did the buyers.

No, no, no. The sellers deliberately and willfully ignored the risk. Contenting themselves with the happy lie that “securitization strips out the risk” in assets. Enron claimed the same thing during their heyday. Truth is securitization adds little to no value for the buyer while created huge moral hazard for the seller.

Of course if securitization isn’t as valuable as propoents claim then all those finance grads will have to find productive work for a change.

I think we all agree that policymakers can make mistakes, but I’m less sure that these mistakes demonstrate that policy per se is bad. I would like the free-market enthusiasts to explain why there were so many financial crises before the advent of central bank regulation of interest rates. Certainly, U.S. history is replete with these debacles. And I would appreciate a reference to any country or society that has had a “free” market economy, anywhere, ever. And if there is no example, why do you think that is?

There are examples of short periods of free banking which, unfortunately, were not long before being stamped out by governments who wanted to reassert or maintain their control of the money supply.

The period in the US leading up to the civil war was relatively close to an era of free banking. It was also a period of extremely fast growth, with minor disruptions as banks would occasionally fail. This is opposed to the current system, where bank failures are rare, but when the failures do occur, they are large, and systemic. This crisis has yet to fully play out, but it is becoming clear that this crisis is far too big for the FDIC to handle, and most likely, the Federal Reserve to handle.

Free-marketeers do not advocate anarchy. Government has the crucial role of regulator but not for intervenor. This is a crucial distinction. Regulation is necessary to create a level playing-field – the reasons are myriad: insider-trading, price-fixing, monopoly breaking(anti-trust) etc etc. All proven essential time and again. But the wholesale interventist policies of modern government is outright damaging control-freakery.

The exceptions are rare.New Zealand under finance minister Roger Douglas (late 1980s) is a virtuous example. Three years of low-tax, low-regulation, no-subsidy, free-market policies set that a failed economy on a path to success. Sadly, 15 years of dead-hand government interventist socialism has since prevailed. But the benefits of even a few years of free-market policies are still being felt there. What a shame it is still a rare example in the world.

Andrew I was in total disagreement with your point of view, in prior posts, until you said “…Free-marketers do not advocate anarchy. Government has the crucial role of regulator but not for intervenor. This is a crucial distinction. Regulation is necessary to create a level playing-field – the reasons are myriad: insider-trading, price-fixing, monopoly breaking(anti-trust) etc etc. All proven essential time and again… “

I’m now confused because my perception of most free-marketers was to minimize any government involvement, even in its capacity of being market’s referee. You no longer sound like a strident free market conformist.

BTW my perception is that the current collapse in the credit markets, was mainly triggered by the real estate bubble, which was enabled, more than anything else, by the misrepresentations of the actual credit risk imbedded in the products and entities (CDO’s, SIV’s)promoted by the purveyors of the structured financial instruments. Then it was further exacerbated by the lack of oversight in the OTC markets for the huge volume of credit default swap insurance that was bought and sold, over the past few years. Bottom line, it was not government action, but rather inaction, that swelled this crisis to its current historic proportions.

Even if the assumption of perfectly rational utility maximizing individuals were correct there is no good reason to think this must hold for the sum total of individuals. What could be true for the one is not at all necessarily true for the other. To imagine otherwise seems a fallacy of composition.

More realistically, that which may be perfectly rational for every particular firm can also be perfectly irrational for the system as a whole.

Taking government to be soley responsible for market inefficiencies is little different than blaming this or that ‘shock'; both methods, most often unconsciously, attempt to absolve the capital system of its internal contradictions by shifting ‘causality’ to a thought to be exogenous terrain.

So Juan, amen to that. Global behavior in a system need not look _anything_ like nodal behavior in a system. That basic concept, amply demonstrated in morphodynamical experiments among other things, that concept ALONE sweeps most neoclassical econ into the ‘con’ file. I dearly wish some of _that_ would get taught in Macroecon 401.

I would agree that the blind belief that markets are perfectly effecient would be a little naive.

However the majority of the recent problems have been due to regulation and distortion of incentives, some by the government(s) and some by the economic participants. Here are just a few things:

***Credit ratings. If credit ratings had not been tightly held by uncompetitive forces then all the ridiculous credit issued may never have happened. Instead rubbish was lapped up on the false and institutionalised belief in such ratings.

Anybody with a few braincells could tell you that a bond yeild 200+ bps above swap is not AAA rated. Yet this is what was happening. The very fact that it was yielding well above swap indicates that many people out there weren’t falling for the sham.

Big players merely following the regulatory requirements of AAA and the naive fell for the trick.

***Poor incentive structure. Company incentive structures for employees rarely in line with company objectives. Investment bank employees have done a VERY good job of maximising their own returns, however this has often been at the expensive of long term company returns.